Flatter taxes are one of the best ideas for raising US revenues – so let’s try
them here

It’s possibly unwise to bet on it, but it still seems more likely than not that at some stage over the next month a deal to fix America’s “fiscal cliff” will be struck that hopefully removes a potent source of uncertainty from the global economy. Failure by Republican leaders to push through their own proposals for averting the cliff is certainly a setback, but not necessarily a fatal one.

If Congress does nothing, then tax rises and spending cuts equal to around 4 per cent of GDP will automatically kick in, with devastating consequences for the immediate economic outlook – hence the term “fiscal cliff”.

Any contraction of such magnitude would make renewed recession a virtual certainty, which is why markets are largely of the view that it won’t happen. That’s not to say there won’t be any squeeze next year. A degree of it is already pre-ordained. The evil day has been delayed quite long enough. But American lawmakers surely cannot be stupid enough to go the whole hog; somehow or other they’ll find ways of avoiding this self-inflicted catastrophe.

That, at least, is the working assumption. All the signs are that the two sides are moving towards a settlement. We’ll see. Yet whatever the compromise, it’s unlikely to provide lasting solutions.

America’s fiscal challenge is both remarkably similar to and quite different from the one facing Europe and Britain. You wouldn’t believe it, listening to the mostly angry debate across the pond around growing public indebtedness and what to do about it, but on one level the US doesn’t really have a significant fiscal problem at all, or not one that Europeans would readily recognise. Its conundrum is that it is fast approaching European levels of entitlement spending, but it is still glued to a tradition of relatively low levels of taxation. It’s possible to have one or other, but almost certainly not both.

This mismatch has been hugely widened by the Great Recession, which has undermined tax revenues while substantially adding to social and other forms of federal and state spending. None the less, the introduction of, say, a European-style sales tax would very quickly resolve the issue. Republicans believe that this route would crash the economy, and very possibly they’re right. Yet they do at least have a choice. They can either stick to the small-state, rugged individualism of America’s roots, or they can become more like the Old World from where many of them originally came.

The same cannot be said of Europe, which already has relatively high levels of tax, and cannot realistically go much higher without most assuredly paying a very heavy economic price. This hasn’t stopped France, which seems hell-bent on economic suicide. In any case, Europe’s fiscal challenge is in this regard a much more intractable one.

However, in other respects the problem is quite similar. If America falls over the fiscal cliff, it will be discretionary spending which is axed first and the Bush tax cuts which are reversed. Unfortunately this doesn’t remotely address the long-term fiscal challenge. The real difficulty is with pension and healthcare spending, which is set to rise dramatically as the population ages.

President Obama wants a deal which not only averts the fiscal cliff but also addresses the issue of fiscal sustainability. Yet he won’t get this latter aspiration without further far-reaching reform in pensions and healthcare. A perfectly sensible strategy for delivering such reform was set out by the bipartisan Simpson-Bowles Commission some two years ago, which proposed lifting the retirement age, broadening payroll taxes to fund social security, and containing the growth in Medicare spending.

But it was the commission’s proposals on the revenue side of the ledger which to my mind struck gold, and provided a blueprint which could usefully be applied here in Britain. The commission recommended the elimination of most tax deductions and loopholes, an initiative that would at a stroke increase revenues by around $1.1 trillion. Some of this “gain” would go towards reducing headline tax rates, and the rest to paying down debt.

One of the Coalition’s many disappointments is that it has failed to address in any fundamental way the manifest inadequacies of our tax system. It’s not just oppressively high levels of tax which are the problem in our economy, but the complexities of a system which distorts incentives and is seen as grossly unfair.

The Simpson-Bowles plan is plainly on to something in seeking to target America’s byzantine system of exemptions and loopholes. Most of them are the result of vested interests of one form or another, or a way of bribing the voters with their own money. Others are unscrupulously exploited in ways which were unanticipated and unintended. The same is true of Britain, where it would make eminent sense simply to sweep the whole lot away and apply the consequent increase in revenues to levelling headline rates of income, capital gains and corporation tax. Indeed, I would gp further and get rid of the charade of corporation tax altogether. For most big, international companies, corporation tax is already largely optional in any case, as Starbucks, Amazon, Google et al have amply demonstrated. But I realise this is far too radical and sensible an idea to command support.

A completely flat-rate tax system is politically unrealistic for the UK and the US, economically optimal though it might be. The concept of progressive taxation has become a deeply rooted cornerstone of the social contract in most advanced economies, and won’t be easily dislodged. But a “flatter” tax system is a perfectly reasonable ambition, and was a key objective of the Tax Reform Commission set up by George Osborne, the Chancellor, when he was in opposition. Needless to say, it has been almost wholly ignored now that he is in government.